My philosophy is that it is hard, but not impossible, to beat the market, and that it is easy, and imperative, to save on taxes and money management costs. I graduated from Harvard in 1973 with a degree in linguistics and applied math. I have been a journalist for 40 years, and was editor of Forbes magazine from 1999 to 2010. Tax law is a frequent subject in my articles. I have been an Enrolled Agent since 1979. You can email me at --williambaldwinfinance -- at -- gmail -- dot -- com.

How to Turn $400,000 Into $1.7 Million

Stock prices lurch up and down for no good reason. Is this volatility bad? No—not, at least, if you are a steady saver.

If you are financially and mentally equipped to add a constant amount to your portfolio every year for a long time, then you should be thrilled that stock prices are so loony. You will benefit as the market swings from irrational exuberance to extreme despondency. The reason you come out ahead is a simple algebraic fact: You will gain more from bargains picked up in bear markets than you will lose by overpaying in bull markets.

It’s the old game of dollar-cost averaging, which means putting a fixed amount every month or quarter into an investment. You end up buying more of your shares at the low prices than you do at the high ones. So your average purchase price is going to be low.

Dollar-costing is of questionable value for individual stocks, because you don’t know where individual stocks are going. Are you buying Exxon or Enron?

But with a market index fund it is not unreasonable to suppose that you know where the shares are headed over a long period: up. Let’s look at what dollar-costing would have done to someone buying the S&P 500 at a constant rate, starting 40 years ago.

We don’t want the results to be warped by either inflation or the declining popularity of dividends. So let’s create an imaginary index fund that owns the 500, reinvests all dividends and incurs no overhead. In real terms this fund’s share price would have tracked the jagged line plotted above in blue.

The rise in the blue line has averaged 6.3% a year over the past three-quarters of a century. That’s not bad, and it’s way better than what you could have earned then or could earn now on safer investments. But there has been terrifying volatility getting from there to here, including four crashes in which prices more or less halved in a short space of time.

Despite the volatility, an imaginary investor we’ll call Mr. Blue sticks it out. Every year, beginning in mid-1972, he puts the equivalent of $10,000 of today’s money into that index fund. His cumulative investment, restated in today’s money, is $400,000. His fund shares would now be worth $1.7 million.

Would savers like this be better served by a steadier market? Nope. Let’s look at what would have happened in an alternative universe inhabited by cool-headed, somewhat prescient investors. They buy and sell stocks at a constant multiple of earnings averaged over a 13-year period that goes back 10 years and forward 3. (The multiple is chosen to make stocks fairly valued, on average, over the 75 years.) The resulting share prices are plotted in the smooth red line labeled “value.”

In the alternative world, gains to investors as a group would be the same, but they would be divvied up in a different way. Mr. Blue would do worse: His $400,000 outlay would merely triple to $1.3 million. The people who would do better are the hotheads who jump into the market near peaks and depart after a crash. Impulsive buying is much less damaging if the asset in question follows a smooth upward course.

Are stocks fairly priced now? To get a red-line value you need to plug in earnings out to June 2015. You don’t know what they will be, but you can guess by picking up Standard & Poor’s analyst forecasts and extrapolating. By this measure it appears that stocks are currently a little overpriced.

Don’t let that stop you. If you are 27 and investing for retirement, put $10,000 into a stock index fund. Keep doing that.

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Excellent advice for a 27 year old. Many people like myself weren’t able to start saving agressively that early due to school, school debt, and a downpayment on a house. Most of my saving started in the late nineties and you know what the chart looks like since then. I’m losing faith in the market though I know I should stick with it.

As a 24 year, just out of college and about to receive his year-end bonus (~10k) and debating whether I should use the money to pay off low interest rate student loans or invest it, this helps me grind out what I need to do, invest. Thank you.

You’re quite right. Stocks can have a bad decade and they sure had one 1999-2009. Japanese stocks are in a 23-year bear market. I am fairly confident that U.S. stocks will show positive real returns over the next 40 years. I am less confident that they will be rewarding over the next 20.

That’s great advice, as usual. Suppose, though, one is 50 years old and just got the $400k in a lump-sum windfall. Would you advise to dollar-cost-average into stocks over many years? Maybe a future (or past?) blog could address this general situation?

Indeed we become slaves of money if we become so intoxicated by its abominable power over us, but if we try to go beyond the usage of it we’ll certainly be glad of the positive repercussions that it will bring.

To some people who want a money increase by just one tick of a clock then this might sound so slow. Well, maybe I would consider the idea 40 years from now but on US stocks. Inflation nowadays is very annoying.